Odhiambo Ocholla
The extraordinary evolution of financial products and instruments over the past two decades, made ever more complicated through continuous innovation and globalisation, has made structured finance the fastest growing specialisation in Investment Banking.
Like much jargon, the term 'structured finance' means many different things to different people: repackaging, credit-linked notes, collateralised loan obligations and securitisation.
Put simply, if you need a diagram to describe a transaction, it's probably a structured finance deal. In the past, structured finance solutions allowed companies to remove assets and liabilities from their balance sheet. However, the new International Financial Reporting Standards with their greater disclosure requirements do not permit many off-balance sheet structures.
Although there are advantages to arranging a structured finance transaction, it is crucial that the borrower fully understands its implications before committing to it.
Different structured finance techniques can be complex, used correctly, but they can provide companies with access to cheaper funding.
They can also provide investors with instruments to suit their own portfolios. Care should be taken to ensure that appropriate structures are arranged.
Perhaps, the basic function of a structured finance deal is a repackaging. An investment bank takes an existing piece of debt (the 'underlying debt') that does not quite fit the requirements of the bank's investor customers - perhaps it is the wrong currency, or the credit rating is not right.
The bank sells the underlying debt to another company and enters into a swap with the company to change the currency or provide some form of credit enhancement.
Structured finance as complex transaction
Originally, repackaging was used as a way of making existing debt more marketable, but lately, we have seen transactions where the underlying debt is specially issued for the purposes of the repackaging, and the latest development is to use it as the underlying debt securities, which are products of a structured finance deal. For example, notes issued out of credit card securitisation can be repackaged into secured corporate bonds, bringing a new type of asset to investors in the Corporate Bond market, and giving borrowers direct access to that market. Structured finance can be remarkably complex.
The borrower needs to understand what the impact of the transaction is and could be. It is important to understand what happens if the transaction goes wrong.
One of the advantages of traditional bank financing is that if difficulties occur, it is often in the bank's interests to restructure repayment obligations. In other words, the interests of the bank and the borrower are often closely aligned.
Under a structured deal, the interests of the lender are represented by repayment. If they can liquidate pledged assets, they will do so, even if it disadvantages the borrower's interests.
Structured finance specialist need be familiar with the law
A structured finance specialist needs to be familiar with the law in a number of areas, such as contract, banking law, securities law, financial regulation, derivatives, tax laws and insolvency. Structured finance can also help a company achieve a more efficient funding balance.
It can help use more assets as security for funding. Using securitisation techniques, the company may well be able to use the assets on its balance sheet to raise funds more efficiently.
In particular, these techniques can be used to help finance receivables, inventory and the purchase and use of equipment. Overall, these techniques can help a company shift the balance of debt to equity without radically increasing the cost of funds.
Although there are advantages for both borrowers and lenders in structuring transactions, as with all deals, borrowers need to be aware of the risks and potential costs. Finally, what next for structured finance?
The developments in particular indicate that more fund raising will use structuring techniques; first the economic situation in the emerging market will make securitisation an increasingly attractive means of fund raising as corporate and banks are increasingly determined to find ways of securitising their own loan portfolios.
Mr. Odhiambo Ocholla is the Head, Corporate Finance and Fund Management with Suntra Investment Bank. Email: ocholla@suntra.co.ke
